Market volatility: new insights

By C. R. L. Narasimhan

Even as investment analysts, fund managers and lay investors are trying to grapple with the ever increasing volatility of the stock markets, leading economists and financial writers too are inevitably drawn in. For them it has been a rather arduous task of formulating new theories or modifying existing ones, the purpose in either case being an attempt to decipher the unpredictable stock market movements.

At another level attempts are on to demystify the dotcom companies, whose earlier share price increases were as phenomenal as they were inexplicable.

Talking specifically of India, it is questionable whether the dotcom factor has had a major impact on share valuations. In a strict sense their influence over Indian stock prices - more specifically on their volatility - ought to be minimal. Although many dotcom ventures have been launched - and extensively advertised - they are still in the process of getting listed on the Indian exchanges. The tendency to equate the dotcoms with Indian infotech companies has been faulted by many. According to this view, Indian software companies, the flag-bearers of the new economy, are showing a good performance and are having a steady and growing income stream. To follow Nasdaq's volatile trends is therefore not correct, says Dr. R. H. Patil, President of the National Stock Exchange.

But in an indirect sense, the dotcom factor is much in the reckoning. The raging debate everywhere is over the future viability of the dotcom companies. There is no consensus. Varying interpretations among stock analysts and fund managers naturally reflect - through their investment decisions - on stock prices. Naturally there has been a great deal of volatility. In our exchanges too, perception-wise, the Nasdaq factor has been one of those important sentiment inducing factors.

Out of the vast and ever increasing literature on the current stock market psyche in relation to the new economy stocks, this column looks at two recent articles of Dr. Paul Krugman (both published in New York Times).

The first article which appeared in the third week of March compares the dotcom ``business model'' to a Ponzi scheme - using money from new investors to pay off old investors and creating an illusion of running a successful business. Drawing extensively from Mr. Robert Shiller's new book ``Irrational Exuberance'', Dr. Krugman explains the connection:

``Imagine, just hypothetically that a new set of technologies - technologies that are really, truly, deeply, fabulous - has just emerged. And suppose also that a number of companies have been created to explore these technologies, in the entirely honest - but hard to assess - belief that they will be able to earn huge profits. For the time being they earn little if any money; even if they earn an accounting profit, they must continuously raise more cash to pay for equipment, acquisitions and so on. Still, as the evidence for a true technological revolution mounts, the prices of their stocks keep rising, producing huge capital gains for early investors. And this attracts ever more investors pushing the prices still higher.''

How about the sceptics? Dr. Krugman continues: ``If the process goes on long enough..... the doubters will start looking like fools and the bears will go into hibernation. Everyone (well almost everyone) may be completely sincere; nonetheless in effect you get a Ponzi scheme without a Ponzi, a scam without a scammer.'' The soaring stock market of recent years, according to this view, is a huge accidental Ponzi scheme, one that will end badly. These observations are applicable to the market as a whole but Dr. Krugman says they read better as a tale of technology stocks.

In the next article, Dr. Krugman discusses the volatility aspects. Writing in early April soon after the great Nasdaq decline, he questions any (explicit or implicit) belief in the rationality of stock market behaviour. And by extension the efficient market theory of stock prices which holds that movements in stock prices should always reflect genuine news about future earnings. The Nasdaq crash on April 4 reverberated across the globe setting in its train a chain reaction whose only common trait is volatility.

Again quoting extensively from Shiller's book, Dr. Krugman explains that the wild swings in the market are mainly self- generated: the same people who bought technology stocks over the last couple of months, because the prices were rising, sold them frantically over the last two days because the prices were falling.'' And he concludes: ``... this level of volatility has got to he bad for business planning, perhaps even a threat to the stability of the real economy.''

Returning to India, what could be the consequences of the continuing volatility? The Securities and Exchange Board of India will forever be concerned and reexamine its volatility containing measures. The SEBI Chairman has said more than once that the system is safe even if individual brokers fail.

However, privately, many including in the Government are worried. Companies which have planned to go to the American markets may have to reschedule their plans, more so if they are dotcom companies. At a psychological level, the wild gyrations puncture the hype associated with the wealth creating aspects. That may not be a bad thing but since any leftover feel good factor also evaporates simultaneously there is a cause for worry.

In the U.S., especially the last point will have more than ordinary significance. If as a result of the diminishing or at least uncertain wealth effect, the American consumer starts spending less, the country's current account deficit will start falling. In turn exports from Asia will suffer as they are mostly dependent on the Americans. So a whole lot of consequences will flow from the current volatility.

Finding a rationale for the current volatility can be as daunting as it is interesting.

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